How companies can combat foreign exchange loss
Monday 11 July 2022
Foreign exchange fluctuations are common in commercial transactions. Foreign exchange fluctuations can be either beneficial or detrimental to the business. Businesses that trade in different currencies are exposed to forex risks.
An example is a Kenyan individual who chooses to buy a certain commodity from an American company in dollars. Assuming that the Kenyan individual only has Kenyan shillings to buy the goods, he will have to convert his shillings to dollars to make the purchase.
A foreign exchange fluctuation can work either for or against him. If the price is set at the time of contracting, and if the shilling loses against the dollar, he will have to pay more to fetch the contractual price in dollars.
This is a simple example of how foreign exchange fluctuations affect international transactions. Many larger businesses feel the impact of foreign exchange fluctuations more. For example, a business that imports goods may feel the negative effect of forex fluctuations to the extent that the business faces massive losses as a result.
It is therefore important for businesses and individuals to learn how to mitigate the risk arising from foreign exchange fluctuations. These fluctuations can work for or against your business. A foreign profit can be beneficial because it can be reported as a business income. A foreign exchange loss can have a negative impact on the business.
For the past two or so months, the Kenyan shilling has lost significantly against the dollar. The loss of value is said to be due to a persistent dollar deficit. From media reports, the deficit is artificial in that many investors are clinging to their dollars creating a deficit. The price of imports is therefore higher and consumers feel more impact.
One way to mitigate foreign exchange risk is to draw up contracts that contain risk mitigation strategies.
One tip is to do transactions in your own currency. If it is a purchase transaction, one can hedge against foreign exchange risk by doing transactions in own currency so that a Kenyan buyer will import goods into Kenyan shillings. The seller will therefore bear the currency risk.
In larger transactions, especially those that are long-term in nature, currency risk clauses are drawn up to reduce losses arising from forex losses. Long-term contracts will definitely be subject to currency fluctuations in the long run. In most commercial contracts, the foreign exchange clause is activated as soon as the losses reach a certain threshold.
In some contracts, the risk is transferred to one party and the party agrees to bear the risk of the foreign exchange loss. It is especially in sales transactions where the seller transfers the risk of an international commercial transaction to the customer. It is important to note for Kenyan exporters exporting various goods and services in the international market.
A third way to mitigate foreign exchange risk is by fixing the exchange rate in the contract. While the exchange rate is determined by market forces and the regulator when it comes to executing the contract, the rate can be determined in advance.
For example, will the applicable rate be at the date of contracting, date of delivery or date of payment of the goods? It is necessary to clearly define the appropriate rate to avoid conflicts in interpretation.
The last option is to provide for contract review if the exchange rate fluctuations are of a magnitude to affect the profitability and performance of the contract.